Taxation (Edexcel A Level Economics A)

Revision Note

Test yourself Flashcards

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Progressive, Proportional & Regressive Taxes

Tax systems can be classified as progressive, proportional or regressive
Most countries have a mix of progressive (direct taxation) and regressive (indirect taxation) taxes in place

Progressive tax system: as income rises, a larger percentage of income is paid in tax (e.g. UK Income Tax; UK Corporation Tax). This system is built around the idea of marginal tax rates

UK Progressive Tax Rates - June 2022
Tax Band
Taxable Income
Tax Rate
Personal Allowance
Up to £12,500
0%
Basic Rate
£12,501 to £50,000
20%
Higher Rate
£50,001 to £150,000
40%
Additional Rate
Over £150,000
45%
Using this system, a salary of £60,000 would attract a tax bill of £11,499.80, calculated as follows:
First £12,500 - no tax
Next £37, 499 at 20% = £7499.80
Final £10,001 at 40% = £4,000
Regressive tax system: as income rises, a smaller percentage of income is paid in tax (e.g. excise duties on alcohol and petrol in the UK; VAT; Air passenger duty). Regressive taxes can have a big impact on low-income households. In 2020 they represented 30% of income for the poorest 20% of households - but only 10% of income for the top 20% of households
Proportional tax system: the percentage of income paid in tax is constant, no matter what the level of income e.g 10% tax is paid irrespective of whether income is £10,000 or £100,000. Bolivia uses this system and the tax rate is 13%

Tax Band	Taxable Income	Tax Rate
Personal Allowance	Up to £12,500	0%
Basic Rate	£12,501 to £50,000	20%
Higher Rate	£50,001 to £150,000	40%
Additional Rate	Over £150,000	45%

The Economic Effects of Changes in Tax Rates

Changes in direct and indirect tax rates influence a range of economic variables
- The greater the size of the change, the greater the ripple effects through the economy

Effects of Tax Rate Changes

Impact	Explanation
Incentive to work	The higher the tax rate, the lower the incentive for the unemployed to seek work - or for existing workers to work overtime In 2022, the Adam Smith Institute calculated that average earners in the UK work from the 1st January to the 8th June (Freedom Day) to pay their taxes - all income after that point belongs to them
Tax revenues	The Laffer curve illustrates the relationship between increasing tax rates and the level of government revenues received The broad idea is that as tax rates increase, a point will be reached where disincentivized workers work less resulting in less income and less government tax revenue. More people will actively seek to avoid paying tax (tax avoidance) or try to move their income elsewhere The Laffer Curve demonstrates the relationship between tax revenue and tax rates Tax rate increases up to point A, will result in an increase of tax revenue. Further tax rate increases from A to B result in a loss of tax revenue from C to D
Income distribution	A progressive tax system redistributes from those with higher income to those with lower income and reduces income inequality Sometimes the benefits of a good progressive tax system are eradicated by the penalties imposed through multiple regressive (indirect) taxes
Real output and employment	If the tax rate increases, more money is withdrawn from the circular flow of income (leakage) This will likely cause a reduction of aggregate demand (AD) as firms and households have less disposable income As AD slows down, fewer workers may be required for production and unemployment may increase
Average price level	An increase in indirect taxes reduces disposable income and so workers may petition their employer for a salary increase If they receive the increase the economy may face a wage-price spiral Indirect taxes also increase costs of production for firms possibly leading to cost-push inflation
The trade balance (X-M)	An increase in taxes can reduce disposable income which is likely to reduce the level of imports This may improve the trade balance (exports - imports)
Flows of Foreign Direct Investment (FDI)	If the rate of corporation tax increases relative to other countries, it may result in less inward foreign direct investment